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By Scot A. Torkelson, Vice President
Business Valuation is a profession which is, first and foremost, based upon trust. The foundation of this trust is the ethical performance of the business valuation professional. In the field of rhetoric, ethics is considered one of the three means of persuasion. In our valuation reports, we establish our moral competence by persuading the clients that the estimated value conclusion is an ethical one. Much is written about ethics in appraisal practice, but there is scant ability to provide any meaningful measure of whether a valuation is ethical or not.
Let's begin with the modern dictionary definition for ethics: "The rules or standards governing the conduct of a person or the members of a profession." All appraisal organizations have established standards to govern the ethics of their members. Key among such guidelines for business valuation professionals are lengthy ethics provisions from: The Institute of Business Appraisers, the Uniform Standards of Professional Appraisal Practice and the American Society of Appraisers (each with its own Competency Rules). In general, we find a special emphasis on objectivity and impartiality set forth in each of the standards. Additionally, considerable time is spent on the importance of an appraisal fee that is clearly and overtly communicated so as to avoid entanglements that may be construed as under-the-table fees for a predetermined value conclusion. Also, within these ethics provisions are the requirements of confidentiality, accuracy, and thoroughness. There are obvious areas of overlap among the guidelines. For those of us in the profession, the guidelines can be summed up by these five words: Objectivity, Independence, Confidentiality, Accuracy and Thoroughness. One might ask: 'How, as business valuation professionals, can we prove that a report meets the above criteria?' and, 'How can our clients know for sure that the value conclusion was estimated ethically?'
Perhaps the modern definition leaves something to be desired. The word ethics comes to us originally from the root words "ethos" (the place of living) and "ethicos" (the theory of living). Predicated within these root meanings is balance: the essence of life being a balance of forces. In order to be ethically competent, and thus trusted by our clients, we must provide balanced value estimates.
SO WHERE ARE WE?
Objectivity and independence are not readily measurable and each person carries his or her own idea of what constitutes objectivity and independence. Confidentiality falls under the category of keeping the client's information to oneself. In certain instances, maintaining confidentiality could actually be unethical (hence the caveat in the ethics provisions: "unless under the direction of a Court"). With regard to accuracy and thoroughness, we have seen many appraisal reports that were accurate in the application of the approaches used, perfectly spell-checked and mathematically sound but, in the final analysis, failed to meet the ethical standard. Ethical conduct in business valuation encompasses more than following a set of guidelines. It must be measurable and the current literature for the business valuation community is inadequate. This article discusses a measurable means of discerning ethical conduct in the area of business valuation.
FIRST MEASURE OF AN ETHICAL APPRAISAL - THE GOLDEN MEAN
Ethics, according to Aristotle, is a mean. That is not to say a mathematical average, but a balance of extremes; the goal being to avoid both excess and deficiency. "Every knowledgeable person avoids excess and deficiency, but looks for the mean and chooses it." He goes on to state that the mean is not a fixed point, using athletics as an example:
"Supposing that ten pounds of food is a large and two pounds a small allowance for an athlete, it does not follow that the trainer will prescribe six pounds at all times; for even this is perhaps too much or too little for the person who is to receive it - too little for the largest of athletes but too much for one who is only beginning to train."
Further, this application of a middle, or a mean, between excess and deficiency is a collective result: an end place on a continuum of choices. Aristotle recognized that at any given point in time a choice may be made that is too few or too much, but that the culmination of choices collectively made, should on the whole be balanced.
"This much, then, is clear: in all our conduct it is the mean that is to be commended. But one should incline sometimes toward excess and sometimes towards deficiency because in this way we shall most easily hit upon the mean that is, the right course."
Conceptually, this ethical guideline can be applied in appraisal practice, because the process of determining value is precisely the application of multiple-choice points which collectively result in a final value conclusion. Throughout the process, there are numerous opportunities to consider each of the factors of a particular company which may indicate "extremes" or "deficiencies." It is the job of an ethical appraiser to keep track of the relative balance at each point of choice within the appraisal.
For example, the history of Company A may indicate very high rates of revenue growth. An extreme rate of growth would therefore be projected relative to a more moderate or mean rate of growth indicated by the national economy, and this would be reasonable. Thus, Company A may have a projected rate of growth of say 10% annually within an industry growing at a far more moderate 3% annually. However, the selection of such an "extreme" rate of growth at the beginning of the process must be properly considered throughout the rest of the appraisal process - in the areas of capital expenditure, profitability or discount rates - in order to retain balance and result in an ethical final value estimate.
Staying with this example, Company A, which anticipates 10% annual growth in revenues is likely to face higher risks than the more typical companies within the industry group growing with the market at 3%. Higher risk necessitates the selection of a higher discount rate on earnings, which serves to balance the excessive growth. A higher discount rate (one higher than the industry would dictate), taken out of context, would appear to be a deficiency. However, the excess of high growth would be offset by the deficiency in the selection of a higher discount rate and, collectively, a balance results. This is the hallmark of an ethical appraisal.
Likewise, while Company A is growing rapidly, capital spending would tend to be higher as well. Company A, growing three times faster than its counterpart Company B, within a given industry (10% growth vs. 3% growth) may also require three times the capital expenditure and three times the working capital than the industry would indicate to provide the fixed asset base for such a sustained rate of growth. If viewed out of context, the higher capital expenditures would appear to pull down the value of the company, yet in response to the higher rate of growth, they serve to balance the final value estimate.
An example of an unethical appraisal then is one where growth is projected at the high range (which may be fully supported by the company's history) - say 10% annually, but the appraiser proceeds to apply an industry average capital cost which does not take into account the higher rate of growth, and then continues with the selection of a discount rate which is also low within the particular industry. There are three excesses in this example - a high rate of growth (justified), a low capital expenditure (not justified), and too low a discount rate (not justified). At each point, the appraiser made the decision which leads to a progressively higher value estimate. The absence of an overall collective balance leads to an unethical final value estimate.
The application of this method of value is precisely set forth by Aristotle's Ethics:
"Ethical behavior is intermediate between doing injustice and suffering it; for the one is to have more and the other to have less than one's share . Ethics is a sort of mean state, only not in the same way as the other virtues are, but because it aims at a mean, whereas injustice aims at the extremes . . . Thus un-ethics consists in excess and deficiency."
SECOND MEASURE OF AN ETHICAL APPRAISAL - THE END DOES NOT JUSTIFY THE MEANS
The elephant in the living room of appraisal is that every assignment carries with it an end depending upon the client. This is a value estimate that is known, desired or, perhaps, implied. Call it a high value or a low value. This end is a challenge to ethics, in that the end may not be right or good, only an end in itself. "In all the states & there is a sort of target; and it is with his eyes on this that a person & stretches or relaxes his string." (Aristotle's Ethics, Book 3)
And here is where ethical considerations must be applied: "There is also a sort of limit determining the mean states which, as we hold, lie between excess and deficiency, and which accord with the right principle." (Aristotle's Ethics, Book 3)
Simply stated, the end exists; it can be seen and acknowledged. For example, assume that a client is engaged in an estate tax matter. Nothing has to be said, the entity being appraised will be taxed and a higher value is subject to a higher tax. A low value is the end in sight for this client. However, the means to reach the end is subject to numerous intermediate choices, wherein the appraiser chooses to stretch or relax his bowstring, so to speak. That said, the second measure of an ethical appraisal is that the end does not justify the means, for the process of determining the means must be followed.
And what are the means? It is precisely the need to retain (to hold to the balance of judgment within the context of the appraisal process) the mean at each of the multiple points of choice to the concluded value estimate. If the end is a low value: does the appraiser choose low revenue growth, low profitability, high capital costs, high discount rates, high minority interest discounts, and high lack of marketability discounts; thus rendering the value as low as it can possibly go?
The appraiser who follows this route and achieves the desired end-without any consideration of the means to get there-has produced an unethical, deficient appraisal analysis. The end does not justify the means.
THIRD MEASURE OF AN ETHICAL APPRAISAL - INTELLECTUAL VIRTUES
The third measure ties closely to the competency provisions set forth in the professional standards. In a nutshell, appraisers must cultivate core competencies, or intellectual virtues, which provide clear indicators of the quality of the valuation work product. Let us consider how the following six intellectual virtues: Honesty, Courage, Responsibility, Humility, Simplicity and Restraint provide the business valuation professional with the means to excellence.
HONESTY
For the valuation professional, honesty means not pretending to know more than you do, admitting to your own errors, and acknowledging others' opinions as valid and worthwhile even when their opinions differ from yours.
COURAGE
It is the willingness to publicly present and defend your professional opinion. The appraiser steps forward and takes the risk of being wrong each time he or she signs a report.
RESPONSIBILITY
The responsible appraiser takes ownership of the work product and does not try to blame others for mistakes. You arrived at the value conclusion and you are responsible for its accuracy.
HUMILITY
The appraiser must separate his or her own ego from the reasoned discourse which will produce an ethical report with its supportable value conclusions. Give credit where credit is due and respect those who hold opinions different from yours.
SIMPLICITY
Communicate your findings clearly and in a manner which the reader can understand. Do not attempt to hide your opinion by using complex calculations or words.
RESTRAINT
Balance your views with a dispassionate skepticism. You could be wrong and if you are an unrestrained believer of your own opinion, you will not see the value in others' comments.
CONCLUSION
It is reasonable to expect an ethical value estimate from the business valuation professionals and that the final value is a measure of the mean. The goal is to be aware of excessive as well as deficient choices and to adjust subsequent choices accordingly (perhaps not precisely, but the mean between the extremes). An ethical selection at each decision point in the appraisal process guarantees a balanced value estimate.
An appraisal is an opinion; your opinion may differ from someone else's, but an appraisal based on the "Golden Mean" produces a value which can be defended. Ethical appraisals reflect the appraiser's balanced approach to estimating a well-reasoned and clearly communicated value while retaining his or her intellectual virtues.
